Submitted by Lance Roberts of STA Wealth Management,
A couple of week's ago I asked the question "How Big Could A Correction Be?" In that article, I compared several different technical models to establish potential correction levels which derived the following table of probabilities. Of course, as I stated at that time:
"There is no exact answer to the potential magnitude of a correction in the markets. 'This' depends on 'that' to occur which is why trying predict markets more than a couple of days into the future is nothing more than a 'wild ass guess' at best. However, from this analysis, as shown in the table below, we can make some reasonable assumptions about potential outcomes."
As shown in the chart below, the recent correction fulfilled the correction to the 2013 bullish trend and got oversold (yellow highlights) on a very short term basis.
With the markets opening higher today, it appears that the short-term correction in the markets may be over as the "buy-the-dip" mentality remains firmly entrenched with market participants.
However, if we step back from the day-to-day volatility by looking at weekly data, a different picture emerges.
As shown, the market registered a signal in early January to reduce equity exposure in portfolios. Importantly, while this does not mean selling everything and running into cash, it does suggest that the markets are egregiously overbought on a short-term basis and investors should rebalance holdings in portfolios. This is done by "trimming winners," reducing holdings back to original portfolio weights, and "selling laggards," which reduces portfolio drag and provides future portfolio tax efficiencies.
After the initial sell signal in January, the market primarily traded sideways for the next several months, with a good bit of volatility along the way. The reduction in portfolio risk reduced overall portfolio volatility with only a minimal drag on overall performance. However, should if the markets had dropped into a deeper correction, investors would have been well positioned to "buy." However, in May, the markets broke out of the consolidation range and the "all clear" signal was given to increase equity risk in portfolios. The consolidation process also allowed for a lower risk entry to add back additional equity exposure.
This process is once again likely being repeated. At the end of July, the markets once again suggested the investors should revisit portfolio holdings and adjust risk accordingly. However, as I stated in the newsletter two weeks ago:
"Furthermore, by the time a WEEKLY sell signal is issued the markets are generally OVERSOLD on a short term basis. It is very likely, that a rally will ensue in the markets over the next week back to resistance which could be used to rebalance portfolios and reduce risks more prudently."
That bounce has now occurred which would suggest that this is a good time to revisit portfolios and make allocation adjustments.
Like gardening, good portfolio management practices consist of processes to "weed and prune." If weeds are not pulled and plants go unpruned, eventually the bounty will rot on the vines, and the weeds will choke the plants out of existence. The same happens in portfolios. Individuals do not "prune" winners, by taking profits and rebalancing, until a significant correction occurs which erases most or all of their gains. Likewise, "losers" are held in portfolios "hoping they will come back." Eventually, individuals wind up with a portfolio full of "weeds" with only memories of the gains they once had.
Outlining The Risks
While the markets are currently suggesting that the "dip" is over, there are several immediately prevailing risks that could catch unwitting investors.
1) The contraction in both Japanese and Eurozone economies.
40% of corporate profits come from international trade. The pop in revenue and profits in the second quarter was not surprising given the drawdown in activity during the Q4 and Q1. However, since the end of the financial crisis the economy has been plagued by sluggish economic growth characterized by rolling recoveries and declines. With retail sales extremely sluggish, imports weak and exports at risk of decline, the impact to both profits and economic data could push markets lower.
2) Mid-term Elections.
The markets like "gridlock" in government as it eliminates the risk of adverse fiscal policies. However, there is a rising probability that conservative Republicans could gain control of the Senate while maintaining majority control of Congress. The impact of such an outcome could be negative for the markets as it increases the probabilities of drastic cuts in government spending, reductions/reform of entitlement programs, and potential repeal, or "fix," of the Affordable Care Act (ACA). While moves to a more fiscally responsible government would provide longer term benefits, such actions would likely trigger an economic recession and stock market correction.
3) Hard landing in China.
Nouriel Roubini recently wrote: "The rebalancing of growth away from fixed investment and toward private consumption is occurring too slowly, because every time annual GDP growth slows toward 7%, the authorities panic and double down on another round of credit-fueled capital investment. This then leads to more bad assets and non-performing loans, more excessive investment in real estate, infrastructure, and industrial capacity, and more public and private debt. By next year, there may be no road left down which to kick the can."
4) Extraction of monetary accommodation by the Federal Reserve
Currently, the markets are still being assisted by the ongoing interventions of the Federal Reserve. As shown in the chart below, via @sobata416, the advances in the market have been closely correlated with Fed's liquidity operations. With that support most-likely ending in October, the risk for equities remains to the downside.
Furthermore, risks of a market correction begin to increase markedly once the Federal Reserve begins raising interest rates.
5) Deflation isn't dead
Despite the Federal Reserve's best intentions to create inflation in the economy, the deflationary pressures on the economy have not yet been vanquished. Wages remain under pressure, employment is muted and primarily a function of population growth, monetary velocity remains extremely tepid and commodity prices have fallen. The following chart was discussed in detail in "Will The Fed Move Too Soon."
"With deflationary pressures from overseas still prevalent, it is very likely that the current uptick in inflation may be fleeting. This potentially could put the Fed at 'risk' of moving too soon to extract support from the economy and beginning to increase interest rates in anticipation of stronger growth."
Something Worth Thinking About
While it is entirely possible that the recent "correction" in the market is over, it is important to remember that what goes "up" must eventually come "down." Despite the best of intentions by Wall Street and the Federal Reserve to ensure that a correction "never" happens again, the reality is that the laws of physics apply to stock market prices just as much as Newton's apple.
The question that you have to reconcile with yourself is:
"When the market does eventually break, will you be prepared?"
History clearly shows that few ever are. While the process of "weeding and pruning" may sound a "bearish" in an overwhelmingly "bullish" environment, the greatest investors in history have all had a disciplined risk management process embedded within their long-term investment strategy. While it sounds simple, "buying low and selling high" is extremely hard for most to do.